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The RBI and memories of the 2008/9 central bankers panic

The Indian rupee rallied sharply to sub 67 per dollar levels on Thursday after the central bank said it would supply dollars to oil companies through a separate window in its latest attempt to shore up the currency.

I am sure that the Reserve Bank of India is pleased with the results of their latest actions. However, it is also clear that the RBI is now conducting monetary policy on a minute by minute basis. It is pure firefighting. It is totally discretionary. The RBI has no monetary rule it follows and monetary policy target. But one thing is certain – this is monetary tightening and the result most likely will be a sharp drop in nominal and real GDP growth. If India enters a recession (I am not forecasting that…) then you would have to blame it on the desperate tightening of India monetary policy to prop up the rupee.

The increasingly desperate actions of the Reserve Bank of India bring back memories to me of what we saw in Central and Eastern Europe in early 2009.

As the crisis was unfolding in late 2008 and early 2009 investors were scrambling for US dollars and investors were basically selling all other currencies in the universe. This was also the case for the Central and Eastern European currencies, which came under massive selling pressures as the crisis escalated.

The Latvian crisis was caused by a monetary shock

At that time most countries in Central and Eastern Europe were running sizable current account deficits. For example in the case of Latvia a current account deficit was in excess of 20% of GDP and for many other countries in the region the C/A deficits were in the range of 5-10% of GDP.

As the crisis escalated the CEE countries were basically facing a sudden stop to the funding of the current account deficits. In that situation you have to choose between either allowing your currency to drop until it is cheap enough to attract currency inflow again or you tighten monetary policy until domestic demand has dropped enough to basically close the current account gap (through a collapse in imports).

The countries operating fixed exchange rate policies – particularly the Baltic States and Bulgaria – thought desperately to maintain their pegged exchange rate regimes. They “succeed” and avoided devaluation. However, the result was a massive monetary tightening and a collapse in domestic demand. In the case of Latvia real GDP dropped in the magnitude of 30% and the crisis caused banking crisis and the country had to be bailed out by the EU and IMF. The peg was saved but the cost to the economy was enormous. Five years later the Latvian economy has still not recovered from the shock.

The 2008-9 CEE Central bankers panic

However, it was not only the countries operating fixed exchange rate regimes in Central and Eastern Europe, which panicked. In fact the central banks of Poland, Hungary, the Czech Republic and Romania also went into full-scale panic even though the officially had floating exchange rates.

A dreadful example was the Hungarian central bank’s desperate rate hike of 300bp from 8.50% to 11.50%. At the time I commented on the actions:

“Will other countries in the region follow suit and hike rates to defend their currencies? This is clearly a possibility, but we would stress that rate hikes not only have a negative impact on growth, but also on the funding costs for banks in the region – which is of course a serious problem in the present situation with a credit crunch.”

I was not impressed then and the desperate actions of the Central and Eastern European central banks in 2008 and 2009 are something I will never forget. They CEE central banks were completely focused on their sharply depreciating currencies – despite of the fact that many of these central banks officially operated floating exchange rate regime. There was a distinct fear-of-floating that caused the them to take desperate and hugely counterproductive actions.

The most shocking event (in Central and Eastern Europe in 2008/9) – in the sense of revealing central bankers incompetence – was probably the decision of the central banks of Poland, the Czech Republic, Hungary and Romania to issue a statement (actually numerous) statements that the four central banks would cooperate to to curb the weakening of the four countries’ currencies on February 23 2009.

As far as remember the whole thing was kicked off when Romanian central bank governor Mugur Isarescu at a press conference said that the four CEE central banks would acted in coordinated fashion to curb the sell-off in the Central and Eastern Europe currencies. Within hours the Polish, the Hungarian and the Czech central banks issued similar statements.

However, there was a major problem. The statements from the four central banks had been extremely badly coordinated so the wording in the statements from the different central banks didn’t really say the same thing. In fact it seemed like particularly the Polish and the Czech central banks really didn’t think that the Hungarian and Romanian central banks were part of the deal. Hence, within hours it became clear that there really wasn’t any coordination between the four central banks other than about issuing statements that they didn’t like weaker currencies. Needless to say within 24 hours the sell-off in the four CEE currencies continued.

There is no doubt that the actions of the Central and Eastern European central banks in 2008 and 2009 to a very large extent were driven by shear panic. At the core of this panic in my view was the lack of clear commitment among the CEE central banks to a clear rule-based monetary policy. Instead of focusing on their stated nominal targets (inflation targeting and floating exchange rtes).

The Hungarian central bank’s desperate rate hike and the failed attempt at coordinated FX intervention were a clear testimony to the failures of discretionary monetary policy. The actions did not stabilise Central and Eastern European markets. They increased volatility and undermined central bank credibility and worse probably deep the economic crisis in all of the countries.

The RBI should end the stop-go policies

This should be a lesson for the Reserve Bank of India. It should forget about trying to prop up the rupee and allow it to float completely freely. Instead the RBI needs to focus on a clear and well-defined nominal target. I would prefer an NGDP target, but even a strict inflation target or a price level target would be much preferable to the RBI’s present stop-go policies.

And in that regard it should be noted that the Reserve Bank of Australia recently has allowed the Australian dollar to weaken as worries over the Asian economies have increased. The result of this strict non-intervention policy is very likely to be that the Australian economy will come through this shock much better than any of the Asian economies where central banks desperately are trying to prop their currencies.

PS Within the last 24 hours both the Brazil and the Indonesian central banks have hiked interest rates to prop up their currencies. It is discretionary monetary tightening, which will only accomplish to deepen the crisis in these countries. I am not too impressed by central bankers in Emerging Markets at the moment. I would, however, notice that the South African Reserve Bank (SARB) under the leadership of Gill Marcus is one of the few EM central banks which has not panicked in reaction to currency weakness. Good job Gill Marcus.

James in London

Isn’t it more simple? They worry about a nonsense concept that you read in the press, “imported inflation”. Sure prices of imports rise, and that can and does temporarily, and immediately, and visibly, “hurt” consumers and manufacturers, and thus voters. The benefits of the falling currency are much more diffuse and harder to quickly see, and need time to work.

James, it might be. Indonesia is a good example. Bank Indonesia hiked interest rates yesterday and they are forecasting inflation around 9% later this year and their target is 4.5%. However, that is CPI. A better measure of inflation is the GDP deflator as it excludes subsidies, indirect taxes and imported prices. GDP deflator is declining sharply at the moment and i likely heading to 2% or below.

James in London

Voters, as Austerians and Finance Ministers point out, don’t face the GDP deflator, but do face CPI. And not very independent central banks face the Finance Minister.

Sadly, even independence of central banks doesn’t seem to mean they understand the difference between CPI and the GDP deflator. Explaining that the keeping the GDP deflator robust matters more for jobs and incomes is our task … Not an easy one!

Lars, I absolutely agree about the need for these currencies to adjust, and that these central banks are delaying the inevitable. Both the Rupiah and Rupee are well out of whack because of persistently high inflation. India’s CPI inflation averages 10% and Indonesia’s is a more palatable 5%+. Neither are new phenomenons – both currencies have seen considerable real exchange rate appreciation over the past decade and are consequently seriously overvalued. I’m thinking they’ll need to lose at least half their Dollar value to reestablish external balance, with the IDR needing a bigger adjustment than the INR. And Vietnam needs a bigger devaluation than either.

BTW, speaking of central banks who are keeping their heads, Bank Negara Malaysia hasn’t budged either – no interest rate hikes, no forex intervention (as far as I can tell), and so far no need to provide Dollar liquidity to the banking system either. The Governor (bless her!) said recently, “What is important for us is to ensure orderly market conditions. We do not focus on any specific level of exchange rate…it (the rate) will be determined by the market.” All this despite the Ringgit depreciating just as fast as the other two R’s.